August 2010 Archive for Dairy Talk

Economists know that dairy prices ride on seasonality and other cause-and-effect waves. They can even roughly predict upcoming peaks and crashes. Shouldn’t dairy policy also look ahead and not just react to 2009?

In 1905, Albert Einstein published his theory that light was actually composed of tiny particles pulsating in waves traveling at, well, the speed of light.

A century later, we learn that the dairy industry also travels at the whim of waves. These waves, like light, are relatively (pun intended) predictable. In fact, economists at Wisconsin and Cal Poly universities were fairly certain in 2007 that milk prices would bottom in February or March of 2009. Boy, did they ever.

The economists, Mark Stephenson, director for the Center for Dairy Profitability at the University of Wisconsin, and Chuck Nicholson, with the Department of AgriBusiness at Cal Poly, estimated the trough of the wave to bottom at about $13/cwt. U.S. all-milk price, give or take $2.

What they didn’t know in 2007 was that the industry was facing two of the largest supply and demand shocks since Ronald Wilson Reagan cut support prices in the early 1980s. Feed costs went through the roof in 2008, driven by ethanol-fueled demand for corn. And in December of 2008, global demand fell through the floor as the Great Recession took an almost death grip on credit and cash flows. The end result: The U.S. all-milk price plunged to $11 in early 2009, and has been struggling to recover ever since.

So, can these wave riders predict the next peak and the next crash? Well, we’ll get to that.

First, you need to understand what’s causing the waves. As it turns out, there are actually four different waves, pulsating at different frequencies and amplitudes.

Wave 1 is a seasonal wave. “We still have seasonality in the dairy industry because we tend to have more calvings in the spring and more productivity,” says Stephenson. “We also have seasonality in demand in the fall, with schools opening and holiday inventory building.”

Wave 2 is a 36-month wave. This wave has the greatest amplitude and it’s increasing over time. Stephenson and Nicholson are not totally sure what causes this wave, but they suspect it’s a supply response to good milk prices. It takes nine months to get a heifer calf on the ground, and another two years to get her in milk. Pretty soon you’re out three years. “It seems reasonable this second wave is a supply response,” Stephenson says.

Wave 3 is a nine-month wave. Again, the economists aren’t sure of causality. “But it would be related to cow numbers and gestation length,” says Stephenson. In other words, when prices are good, producers keep and breed more heifers (that’s what the cowboys do). Nine months later you have more cows milking.

Wave 4 is a 26-month wave. This one’s a puzzler, because it’s not really tied to biology or normal demand cycles like schools opening or Super Bowl pizza parties. “It’s still a mystery, but if you think outside the box a little bit, it might be related to new cheese plant openings,” says Stephenson.

Every few years, some large cheese manufacturer announces it is building a 3-million pound per-day plant as Phase I of a plant expansion. Two years later, the plant is complete and dairy producers start filling it. Think Idaho; think Texas. “These plants are big, and they’re really lumpy on the demand curve,” says Stephenson. “They create huge new demand for milk, and you get an almost immediate supply response.” And then a year later, the cheese manufacturers announce Phase II—and the cycle starts over.

So what does this all mean for future prices? If all things were normal, Stephenson and Nicholson would expect the next trough to occur in 2013. “But it is not at all clear that will be case,” says Stephenson.

The feed cost and demand shocks of 2009 were so severe that they could have reset three of the four waves that determine prices. Producers, processors and their lenders are all running scared. Many lenders now require 50% equity levels on new expansions—after the expansions are complete. That alone will hit the reset button, and could well dampen the amplitudes of the 36-, 9- and 26-month wave cycles.

The bigger point is that future dairy policy should be future oriented, and not totally reactionary to 2009. The depth of 2009 prices occurred when all four waves troughed simultaneously with the feed cost and global dairy demand shocks. The probability of that happening again is low, extremely low.

Yes, some safeguardsshould be put in place to prevent future catastrophes. But the policies should not be so restrictive that they don’t allow the U.S. to compete for new and growing global markets. Constrictive supply management programs and sky-high dairy support prices just won’t get us there.

Like big banks in the depths of the Great Recession in early 2009, it appears big dairies are also “too big to fail.”

Yes, there have been a few humungous failures—like the fiasco in Colorado with the bank belly up there and undercapitalized Dutch dairies in Indiana. But for the most part, lenders are choosing to ride out the storm along with their big dairy clients. “The blinking has been done,” one lender told me. “I don’t think you’ll see wholesale abandonment of dairies.”

One reason is rebounding milk prices. Lenders are hoping the light at the end of the tunnel is a rebounding economy, and not another train wreck in the making

But the biggest reason? If lenders liquidate dairies, asset values on all of their dairy properties will deteriorate badly. That will put more and more of their portfolio at risk, snowballing into an avalanche that would wipe out all but their stoutest borrowers. If lenders can avoid that, they will do so as long as state and federal bank regulators go along.

As another lender told me, regulators seem willing to play the game. While ag lender equity positions have eroded over the past 20 months, they are still in a much stronger position than banks which have large commercial real estate holdings. If ag lenders start liquidating their underwater dairies, they’ll be in the same mess as their urban cousins.

It’s a good news/bad news situation. It’s good news for those highly leveraged dairy producers who want to remain in the business. It’s bad news for everyone else because the highly leveraged continue to milk cows and contribute to growing milk output.

Even California, which by all accounts should have dropped into the Pacific by now, is rebounding. In June, milk production there jumped a whopping 3.5%--mostly on the strength of more milk per cow, which was up 120 lb. or 3 lb./cow/day. Cow numbers lagged June 2009 by 53,000 head but were up a thousand over May 2010. (And tomorrow, we’ll get the July numbers.)

The assumption is that every dairy in California was and still is bleeding red. Not true, says Michael Swanson, an ag economist with Wells Fargo, which finances a large number of dairies in the West.

It is true that the average feed cost in California is about $10/cwt., he says. But there’s a $3 to $4 swing in feed costs depending on how smart, savvy or lucky an individual producer was in buying feed. Total cash cost of production can range from $13 to $18/cwt., depending on the individual dairy, he says.

So if most producers have weathered the storm, does this mean we’ll see widespread expansion? Absolutely not. Dairy profits, fueled by cheap money and cheap feed, had a pretty good run since the mid-90s, say my lender sources. Yes, there were bumps in the road, but highly leveraged dairies were able to cruise over those potholes with little damage—until last year.

Now, lenders are tightening up. Any new expansion will have to be secured with 50% equity—after the expansion is complete. In other words, lenders will be requiring a whole new level of liquidity to withstand the increasing volatility in feed and milk prices.

In reality, access to capital will become the industry’s new supply management program. Only the very best managers, who can manage cows, labor and risk to bank consistent profits, will be rewarded with more borrowing capacity. That’s the way it should have been all along.